Manipulations of the LIBOR rate, while minuscule to most
individuals, had much more substantial effects in the money
markets, where banks go to borrow money from each other and hedge
against changes in lending and interest rates.

The chief strategist of a firm that specializes in brokering
deals on Eurodollar futures contracts told Business Insider that blaming
bankers for manipulating LIBOR misses what's really happening in
money markets; LIBOR is still being distorted, and on an official
basis.

That's why, he argued, the old way of monetary financing—and with
it, LIBOR fixings—has been destroyed in the wake of the financial
crisis.

"It didn't seize up [during the crisis]. It ceased to
exist," he told Business Insider.

Understanding what he means takes some understanding of how LIBOR
works and what its fixing affects and is affected by.

LIBOR isn't really based on a tangible number; it's based on a
compilation of bank responses to the question, "At what rate
could you borrow funds, were you to do so by asking for and then
accepting inter-bank offers in a reasonable market size just
prior to 11 am?"

Banks need to find money to settle transactions denominated in
other currencies or involving transactions abroad. Therefore they
use instruments like Eurodollar futures, which allows them to
borrow or lend dollars at banks outside the United States for a
certain period of time.

The effects of any central bank action are felt directly in these
markets. When the Federal Reserve wants to lower the federal
funds rate, it uses open market operations—this means it states
its intention of depositing more money in banks' accounts at the
Fed, making it cheaper for other financial firms to get dollars.

In the years leading up to the financial crisis, the relative
stability in rates allowed algorithmic traders to take advantage
of very minute changes in LIBOR at various maturities, like those
mentioned by Barclays traders in documents released by
European regulators. The Fed and other central banks could
control that rate by adjusting interest rates, but LIBOR moved
pretty much in tandem with the federal funds rate.

(Click for larger image.)

The spread between LIBOR and the effective federal
funds rateSimone Foxman/Bloomberg
Data

"My colleagues and I, we say that [LIBOR] is 14 bps over the
federal funds rate...as a joke," the trader told Business
Insider, pointing to the uncanny correlation between the two
rates up until 2007 and since 2009. When the rate at which banks
lent to each other began to jump in late 2007, however, "the
system couldn't take it at all," he added.

In the lead-up to and during the financial crisis, real
interbank lending for any length of time beyond overnight
practically stopped. Thus, saying that banks were pushing
down their reports of the prices at which they could borrow is at
best misleading, because the demand for lending long-term was
nonexistent.

"We submitted a hallucination," said the source.

Central banks responded to the credit stress by offering massive
lending facilities, which allowed banks to to access money—in
particular, dollars—through a vehicle outside the traditional
private money markets. That has changed the way the markets work.

The trader explained, "Since the crisis, banks don't fund
themselves [through the traditional money markets] because they
don't want to. It's really now about old contracts," that were
purchased ahead of the crisis.

But while markets may have exited the crisis credit crunch,
markets for securities determined by LIBOR have not, the trader
told us. Instead, he says there's an implicit push by the Fed to
keep the lending rate low, even though it should be much higher
now.

By releasing interest rate projections and jumping to
non-standard measures like quantitative easing and dollar
facilities, the Fed destroys the incentive to actually exchange
money via Eurodollar contracts. This means the Fed is
refusing to let LIBOR function as a true, independent
indicator.

"If you're long the TED [you believe there will be more financial
stress] in a time of trouble, you buy T-bills and take the money
offered to you, so you sell a Eurodollar." Essentially, you
believe you'll be profiting off of higher lending costs for banks
in the future. But if the LIBOR is kept artificially low, then
you lose money on a Eurodollar futures contract.

But now, the Fed has become so committed to keeping
interest rates down indefinitely—and has jumped so quickly to
measures that distort the market—that it has completely destroyed
any faith or interest in new contracts.

The trader believed that central banks have recognized that
disaster happens when the LIBOR begins to deviate from its
general relationship to the federal funds rate, and therefore the
Fed (and perhaps other central banks) have suppressed it to make
sure rising rates don't generate fear while it develops another
money market system.

"I think what they want to do is make sure the system
doesn't go crazy." Otherwise, he argues, "You're not
just embracing a fantasy. You're embracing a fantasy that created
the great credit bubble."

Central bankers will meet in September to discuss changes to the
LIBOR system, and it is believed that they could use this moment
to develop a complete alternative to rate, and thus the money
markets it governs.

If you can help us better understand this, are connected with
LIBOR and related securities, or are involved in any current
investigations, please contact Simone Foxman at
sfoxman@businessinsider.com or call +1-646-376-6016
(U.S.).